The latest Obama Administration initiative aimed at easing the nation’s foreclosure crisis may be well-intentioned, but fails to give proper consideration to the state of the housing market. The biggest winners are likely once again to be the banks. In particular, holders of second mortgages are likely to see this program as a huge bonanza.
The program provides a substantial incentive for holders of first mortgages to reduce principal by having the Federal Housing Authority (FHA) guarantee a new loan at 97.75 percent of the current market value. In many cases this would be far more than the holder of the first mortgage would collect if the loan went through a foreclosure process. However, the payment on the second mortgage would be unaffected.
By substantially reducing the required payment on the first mortgage, the program will be creating a situation in which the second mortgage — which would be worth little or nothing in foreclosure — will suddenly again hold considerable value. This will be a huge windfall for second mortgage holders. It is worth noting that the major banks have vast portfolios of second mortgages.
In the current market, the newly guaranteed FHA loans are likely to incur substantial losses. Nationwide home prices remain about 15 percent above their long-term trend. There is an enormous oversupply of housing at present as indicated by falling rents and a record nationwide vacancy rate. In addition, there will be an obvious problem of adverse selection as lenders will be most likely to take advantage of this principal write-down process in markets where prices are expected to fall further.
If the purpose of this modification program is to help homeowners, then any policy must ask two simple questions.
- Is the homeowner paying less in ownership costs than they would to rent a comparable unit?
- Is the homeowner likely to end up with equity in their home if they sell it in the next 3-5 years?
Both of these questions require an assessment of specific housing markets. If the market is still bubble-inflated, then the answers to these questions will be no and any money spent on modifications will be helping banks, not homeowners.
For some reason there is an enormous reluctance to ask these basic questions about the housing market. The failure to ask these questions in the years 2002-2006 provided the basis for the housing bubble. The government still failed to ask these questions last year as the FHA hugely expanded its role in the housing market. The result was that the FHA lost tens of billions of dollars and fell below its minimal capital requirements. The continuing failure to consider the state of the housing market when designing policy can only lead to further losses to taxpayers in ways that provide no benefit to homeowners.
Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of False Profits: Recovering from the Bubble Economy. He also has a blog Beat the Press, where he discusses the media’s coverage of economic issues. This statement was published by CEPR on 26 March 2010 under a Creative Commons license.